Letter To A Friend. {Part II}

Having an investment strategy seems less important when markets are advancing. It becomes paramount to investor’s thinking when markets decline. That’s when they should be asking advisors; what is the plan for when things go wrong? Most of the time when “things go wrong” it is during a market decline.

I believe you define market declines in two ways. One is a secular decline or bear market decline similar to what we experienced in 2000-2003 and 2007-2009. That is a series of fundamental or geopolitical events that causes investors to withdraw liquidity {that is they are net sellers of securities} from the market in question. The other type of decline comes from market volatility. Most years stocks will experience a pullback that can be anywhere from 10-20% from high's to lows. Take this year as an example. Stocks are currently up about 10% this year. But between April and mid-June, high to low stocks declined close to 20%. I study how money flows into and out of equities to look at bullish and bearish cycles in short, intermediate and longer term time periods and my analysis shows that so far in 2010 we have experienced four bearish phases and four bullish phases.

It is important that investors understand that markets will decline and that at some point a decline is inevitable. Unless your focus is almost 100% devoted to very short term trading, your assets invested in equities will decline at some percentage rate of the market when it goes lower. Warren Buffett is regarded by many as one of the most successful investors of all time. You can invest along with Buffett by buying his holding company Berkshire Hathaway {Symbol BRK.A}. Investing along with Buffett would not have protected you from market declines. Berkshire lost over 50% during the last bear market.

While a few investors may have managed to avoid the losses that occurred in 2007-2009, I think that if people like Buffett lose money in these times than so will the vast majority of investors. The trick in market declines is to devise strategies that fit investor’s unique risk/reward criteria. In short investors should have a plan to deal with these periods. Such a plan will hopefully mitigate losses during downturns. If your assets decline less than the market and have performance that at least matches it when stocks go up you will over time do not only better than the markets but probably better than most investors

Part III coming Monday.
 
*No position in BRK.A but it may be a component of various ETFs we own in client accounts.